Monday, August 29, 2011

On a six-month annualized basis, using the Fed's preferred measure of inflation (the Personal Consumption Expenditures Deflator), both headline and core inflation are above the Fed's target range of 1-2%. As recently as late last year—about the time that QE2 got underway—both measures were below the Fed's target range. We're now back to a 2-3% inflation environment, much as we were in the years leading up to 2008.

What has changed so much since late last year? This second chart gives us a clue: durable goods prices are no longer deflating. In fact, durable goods prices have risen at a 1.2% annualized rate since the end of last year, and that's the first sustained rise in durable goods prices since 1994. The seemingly relentless decline in durable goods prices was a major factor holding down overall inflation for the past 16 years, but that's no longer the case.

The above chart shows the three major components of the PCE deflator: services, nondurable goods, and durable goods. Note the dramatic differential between the rise in service and non-durable goods prices, and the decline in durable goods prices. Since the end of 1994, service sector prices have risen 57%, nondurables have risen 47%, and durables have fallen by 27%. Since 1994, service sector prices have more than doubled relative to durable goods prices. Since service sector prices are dominated by labor costs, that's roughly equivalent to saying that an hour's worth of work today buys more than twice as much in the way of things (e.g., autos, TVs, appliances, computers) as it did 16 years ago. That's a unique, and for most folks, a very fortuitous development, since prior to 1994, durable goods prices never declined on a sustained basis. Unfortunately, those good times look like they have come to an end.